Debt, currency and equities – and the EU and US approach

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By Cormac Lucey

One of the greatest economic challenges of the age is that of deleveraging. Having built up huge levels of deb mountainous debt levels over recent decades, how is the world to gradually reduce them? Ray Dalio, the founder of hedge fund Bridgewater Associates, wrote an article a few years ago titled “An In-Depth Look at Deleveragings” that examined how to resolve the challenge.

Dalio concluded that the difference between how deleveragings are resolved depends on the amounts of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4) debt monetisation/inflation. Successful deleveragings balance these factors well: unsuccessful ones don’t. Over the last number of years, we have seen these four strategies attempted.

There has been debt reduction as more old loans have been repaid than new loans taken out. There has been austerity that has seen belts tightened as an alternative to borrowing more. Within Europe, money has been transferred from creditor countries, such as Germany, to debtor countries, such as Greece (even if the Germans still insist on getting that money back).

But where is the debt monetisation and inflation? Since 2008, the developed world has seen no inflation of note. This matters as its absence makes the real burden of debt harder to bear. Inflation helped reduced debt burdens in the past: between 1946 and 1955, the debt/GDP ratio was cut almost in half in the USA. The average inflation rate over this period was 4.2%. Over a decade inflation thereby reduced the real 1946 debt/GDP debt burden by almost 40% within a decade.

To date, it is the US economy which has come closest to reigniting the inflation genie. Last August, the vice-chairman of the Federal Reserve Stanley Fisher Fischer told a central bankers’ gathering in Wyoming “Given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further.”

Rising US inflationary pressures and a desire to rest monetary policy setting back to normal before the next economic crisis hits, have already prompted the Fed to increase its base rate in two quarter per cent hikes over the last eighteen months.

And last week Federal Reserve Chairwoman Janet Yellen said that another interest-rate hike is likely at the U.S. central bank’s policy meeting next week. Was it Donald Trump – and the unleashing of animal spirits on the world’s stock markets that accompanied his election last November – that finally triggered these inflationary pressures?

In a word, no. When the cock crows, it doesn’t cause the sun to dawn however much its good timing might suggest otherwise. Employment in the US has been steadily growing for several years. As a result, the unemployment rate has been falling there and is back down at a level that, in the past, has seen inflationary pressures build.

Of greater is what is happening on this side of the Atlantic. Here the former governor of the European Central Bank (ECB) Jean-Claude Trichet spent several years after the crisis broke according a higher priority to preserving unity within the ECB’s inner councils than to resolute action to boost the ECB’s economies. Quantitative easing (QE) was used only tepidly as a device to promote debt monetisation and inflation. And, in a bewildering act of self-harm, the ECB actually raised its base rate twice in 2011.

It was only with the arrival of Mario Draghi to the ECB’s top job that things changed. People may bemoan the years Draghi spent working for Goldman Sachs. But at least people from Goldman Sachs can act decisively and generally know what they’re doing.

Supermario did two things that raised the prospect of debt monetisation and inflation in the eurozone. Firstly, he signalled that the ECB was ready to die in the ditch protecting the eurozone when he said publicly that it would “do whatever it takes to preserve the Euro. And believe me, it will be enough”. He issued that call without having previously consulted his ECB colleagues – leadership had replaced bureaucratic paper-shuffling.

Secondly, in early 2015, Draghi won over a majority of his ECB colleagues to a strategy of aggressive QE. Last March, Draghi increased the monthly pace of QE asset purchases from €60 billion to €80 billion and started to include corporate bonds under the asset purchase programme and he announced new ultra-cheap four-year loans to banks.

Now eurozone inflationary pressures are finally stirring. Earlier in the month, Eurostat – the European Union’s statistical office – reported euro-area consumer prices rose at a 2% annual rate in February. Inflation has sharply risen from December’s 1.1% rate, and is now in line with the ECB’s official target. The key question to be considered is whether the recent rise in prices represents a blip or a real rise in underlying inflation? It would appear to mostly blip. The core eurozone measure of inflation (or Harmonised Index of Consumer Prices – HICP) remains steady at about 1%.

Nonetheless, the gradual decline in HICP which had preceded the ECB QE programme has been stemmed and partially reversed. So even if Draghi’s QE programme hasn’t made things dramatically better, it would appear to have prevented them from getting any worse. Will core eurozone inflation follow the US pattern and start to trend upwards? I’m not sure that it will.

The US employment market has tightened and is now in about the same state that it was in 2006, when the US economy was running at close to full capacity. But unemployment in the Eurozone remains relatively high, suggesting that there is considerable slack for further employment growth before significant inflationary pressures are unleashed.

If inflation in the common currency area does begin to take off, what then? There is little doubt that the ECB would follow the Fed and seek to normalise monetary policy by ending QE and starting to raise interest rates. But there is little doubt that the Eurozone is in a more fragile state than the US economy: Greece remains a basket-case and there are still big question marks hanging over Italy, Portugal and Spain. That would suggest fewer interest rates ahead for us than for the US and on a more delayed schedule.

A larger question concerns how global equity markets react to the tidal change in interest rates. At first, equity markets can shrug off a few interest rate rises. But as they gather pace and accumulate, they increase the cost of borrowing money to fund the purchase of expensive assets. That inevitably puts pressure on the value of equity and property assets.

Remember, it was the ECB’s raising of interest rates from late 2005 onwards that eventually sucked the air out of the Irish property bubble. A determined Fed interest rate raising cycle might do the same for the bull market in US equities.